Kickstart your trading analysis by understanding short term price action strategies
In part 1 of Reading the Market, we looked at Understanding General Price Action Trading. In this article we’ll drill down further and look at getting a handle on the short term price action strategies.
Analysis of individual bars on candlestick charts is the key to understanding price action strategies. This is not as exciting as an array of colourful indicators and requires additional time and effort but the results are well worth it.
This analysis is equally applicable to any time frame, although your initial reaction may be that this is only for the short term trader. It is equally important to have an accurate assessment of the current price action regardless of your time frame and this is easy to achieve using most charting software packages.
When using candlesticks to analyse price movement, the following needs to be considered;
Candlestick Body Size
The size of the body of the candlestick is an indication of the commitment of who’s in control of the market, buyers or sellers. A large body, green (or light coloured) candlestick indicates that the buyers are very committed to this stock, as they are prepared to accept increasingly higher prices to take a position. A large body, red (or dark coloured) candlestick indicates that sellers are highly committed.
Likewise, if the size of the body is small, it’s an indication there’s indecision and a lack of commitment.
Don’t forget that you need to look at the candlestick body size in relation to preceding candles. A large candlestick following a number of smaller body candlesticks holds more weight than if the candlesticks preceding are also large and opposite in colour.
Large candlestick tails are an excellent indication of a potential change in sentiment. In order to create a large tail on the top of a candle, the buyers must have pushed the price right up to the top of the tail and then sellers have entered the market and pushed the price right back down. This means a large tail on the top of a candlestick is a bearish signal and indicates that the sellers are in control of the market at the end of that period.
If there are large tails on the bottom of candles, then sellers have pushed the price down to the bottom of the tail and then buyers have entered the market and pushed the price back up. A large tail on the bottom of a candlestick is a bullish signal and indicates that buyers are in control.
So you can see from analysing individual candlesticks we can determine a lot about the actions of buyers and sellers in the market.
The next important step in your analysis is to consider the most recent price action over a number of periods. There are many names attributed to a variety of patterns created by a set of candlesticks. Our approach is to apply the same rigorous analysis to a set of candlesticks as we do to individual candlesticks. This then provides us with a clear picture of what has been happening in the market.
As an example, let’s take the typical flag pattern, consisting of a number of large body green (or light) candlesticks, followed by a number of narrow range red (or dark) candlesticks. Here’s an example of what a flag pattern looks like;
Based on our approach above we would look at this pattern as follows:
The set of large body green candlesticks indicate that the buyers are very committed to this stock. This would particularly be the case if the body range is also increasing. The set of red candlesticks following this rise indicates that sellers have come into the market. However, they are narrow in range and as such do not display a high level of commitment from these sellers.
You can see from this one example how detailed price analysis will give you a picture of what is actually happening in the market in the short term. This is a particularly important skill when recent price action doesn’t fall conveniently into a normal pattern formation.
Short Term Price Action Strategies: The Bottom Line
Key Message: Once you have determined the general price movement, use candlestick body size, tails and groups of candles (or patterns) to evaluate short term price action strategies and understand who’s in charge of the market; buyers, sellers or neither.
Congratulations! You’ve completed part 2 of our 3 step system to learn how to read the markets!
Become a market master by completing our Reading the Market Part 3: Understanding Trend Trading